The Securities and Exchange Commission (SEC) has charged a Bay Area hedge fund manager with concealing more than USD12 million in investment proceeds that he owed investors in his fund.

The SEC alleges that Lawrence R Goldfarb of Larkspur, California, and his company Baystar Capital Management LLC (BCM) instead diverted the cash to other entities he controlled, ultimately funding a real estate venture and a San Francisco record company. Goldfarb also comingled investor funds in a bank account that he used to pay for unauthorised personal expenses including entertainment and charitable donations.

According to the SEC’s complaint filed in federal district court in San Francisco, Goldfarb and BCM were able to carry out their fraud in part because the investment was maintained in a “side pocket” into which investors in the hedge fund – Baystar Capital II, LP – had limited visibility. A side pocket is a type of account that hedge funds use to separate particular investments that are typically illiquid from the remainder of the investments in the fund. Goldfarb’s side pocket investment became profitable in 2006, but he diverted the proceeds for other uses rather than paying the fund’s investors. None of his transactions were authorised by the fund’s partnership agreement or offering documents.

Goldfarb agreed to pay more than USD14 million to settle the SEC’s charges.

“Goldfarb betrayed the trust of his hedge fund’s investors, keeping them in the dark about their investment profits so he could use their money as his own,” says Marc Fagel, Director of the SEC’s San Francisco Regional Office.

Robert Kaplan, Co-Chief of the SEC Enforcement Division’s Asset Management Unit, adds: “Hedge fund managers may not use side pockets to obscure their activities from investors. Hedge fund managers need to honour their obligations to investors, and investors should pay close attention to the discretion that managers wield over side pocketed investments.”

According to the SEC’s complaint, Goldfarb and BCM concealed the fraud for several years by providing investors with false account statements showing no gains had been realised in the side pocket. This falsely indicated that the side pocket investment had not yet distributed any profits to the fund, and investors were unable to determine that they were entitled to distributions. Generally, investors can only withdraw their side pocket investments once the underlying position has been sold or liquidated. This helps ensure fairness by limiting the ability of an early-redeeming investor to withdraw a disproportionate share of the fund’s liquid assets.

The SEC alleges that Goldfarb also took steps to conceal the side pocket profits from the fund’s third party administrator. For example, he directed money to the bank account of an entity that no longer existed.

Without admitting or denying the SEC’s allegations, Goldfarb and BCM consented to permanent injunctions against violations of certain provisions of the federal securities laws and to pay disgorgement of USD12,112,416 and prejudgment interest of USD1,967,371, which will be distributed to the fund’s investors. Goldfarb also agreed to pay a USD130,000 penalty, be barred from associating with any investment adviser or broker (with the right to reapply in five years), and be barred from participating in any offering of penny stock.